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The old proverb “may you live in interesting times” certainly applies to the bond market these days. It has been an extremely volatile year so far, with Government of Canada 10yr bond yields dropping from 1.80% at the start of the year to a low of 1.24% in February. But since then they’ve bounced right back up to around where they started!

As you may know, bond prices move inversely with yields. The recent rise in yields has hurt bond prices, resulting in negative returns across the board. For example, the FT TMX Canadian Bond Universe index has declined by -1.5% over the past three months as at the end of May. However, it is still positive +3% for the year-to-date1.

Why the volatility? The main factor driving yields down to their lows was the European crisis. The German Government 10yr bond yield, for example, hit a low of 0.07% in April, and some shorter-term yields even fell below zero as the fear of deflation, and the prospect of Quantitative Easing, permeated Europe. North American yields fell in sympathy as they began to look quite attractive relative to their European counterparts.

Since Europe was the main force driving down Canadian bond yields, it is only logical that Europe was also the primary factor pushing them back up again. Recent economic data in Europe has surprised on the upside, causing German 10yr bund yields to rise by a massive 80 basis points since April, from 0.07% to 0.87%. In North America, the economic data has been somewhat mixed. However, we did have a strong payroll report last Friday and the probability remains high that the U.S. Federal Reserve (the “Fed”) will begin hiking rates later this year.

Where are bond yields going from here? Nobody knows for sure but our base case is that they will not rise much higher for a number of reasons. First, Europe’s structural problems are far from over, the recent cyclical economic uptick notwithstanding. Second, on a secular basis, economic growth and inflation are expected to be generally lower than they were in the past, due mainly to debt and demographics. Third, the bond market is already discounting a new Fed tightening cycle. When the Fed finally does begin tightening, the bond market may be more relieved than shocked. The real action in the bond market will probably be if the Fed doesn’t hike.

Although our base case is relatively benign for bonds, we do have a plan if it looks like yields are instead going to trend sustainably higher. There are a number of strategies that we can employ to help protect the bond portfolios in a rising yield environment such as shortening duration by selling longer-term bonds in favour of shorter-term bonds, overweighting corporate bonds which tend to outperform as yields rise, and purchasing floating-rate notes.

I will end with a reminder that rising interest rates generally reflect improving economic conditions. In other words, if bond returns are negative, other asset classes such as equities will likely be positive, and vice versa. Therefore, it is vital to maintain a well-balanced, diversified portfolio.